Hotel real estate investment trusts (REITs) and their investors have taken a severe blow due to the intricate setup of the hotel industry. The publicly traded REITs have utilized variable-rate interest-only mortgages in a climate of extremely low-interest rates, leading to these hotels being held by commercial mortgage-backed securities (CMBS) with inflated property valuations. These factors, coupled with increasing interest rates and plummeting hotel property valuations, have created a precarious situation where REITs are walking away from their properties, leaving the CMBS holders to bear the financial losses.
1. In a complex cycle, hotel REITs hold hotel properties, which then leverage them with variable-rate interest-only mortgages, which are subsequently securitized into CMBS and sold to investors. When the Federal Reserve increases its policy rates, these variable rates increase, causing mortgage payments to roughly double while the values of hotel properties decrease. As a result, hotel REITs incur losses when they walk away from properties, while CMBS experience remaining losses when selling these properties.
2. A large and recent player in this situation is Ashford Hospitality Trust, a Dallas-based hotel REIT, which plans to walk away from 19 hotels due to an inability to maintain debt service on 3 mortgage pools. Two attempts to sell pools did not receive sufficient bids. The action, which the company says is an economic decision, would save Ashford Trust a $255 million down payment and $80 million in capital expenditures through 2025, handing losses to the CMBS holders.
3. Another example is Hilton-spinoff Park Hotels and Resorts, which, due to mismanagement, lack of necessary investment, and over-leveraging of properties, walked away from a $725 million variable-rate interest-only mortgage associated with two large hotels located in San Francisco. Upon departing from these two properties, Park Hotels now holds just 44 hotel properties, down from 67 at the time of its spinoff.
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Hotel Real Estate Investors Facing Massive Losses Due to CMBS Defaults
Have you ever wondered why big corporate decisions can affect your seemingly unrelated investments? Keep reading to find out. Today, we’re talking about the soaring rates of defaults on commercial mortgage-backed securities, or CMBS. These defaults have hit institutional investors hard, but why does this matter to you?
The Domino Effect of Defaults on CMBS
Let’s break down the domino effect, but in terms, a fifth-grader might understand. Imagine you’ve built a towering stack of blocks, each stacked on the other. Everything seems fine while it’s all in balance. The hotel properties, managed by other companies and broken down into smaller chunks (mortgage-backed securities), are balanced, sold to investors (like your pension fund or bond fund), and backed by towering property valuations. When the bottom block (in this case, the fluctuating interest rates) gets wobbly, the whole tower can come tumbling down.
How Real Estate Investment Trusts (REITs) and CMBS Connect
Now, who is getting crushed here? It’s the investors in hotel Real Estate Investment Trusts or REITs. These investors were all in on hotels that were backed up by variable-rate interest-only mortgages. But when the Federal Reserve decided to hike its policy rates, these mortgage rates spiked, and property values fell back. The result? REITs started to abandon the properties, riding off with a total loss on their equity. The CMBS holders are left to deal with the remaining losses when they sell the properties at market value because the proceeds are not enough to cover the loan balance.
Why Does This Matter to You, the Investor
You may be thinking, “I’m not a big institutional investor—why should I worry?” Here’s why: The hotel sector’s struggles shine a light on a wider issue—over-leveraged corporate debt. It shows how dramatic shifts in interest rates can have far-reaching impacts on businesses and, by extension, your investments. Learning from their mistakes and understanding the market dynamics can protect your investment portfolio and potentially even identify profitable opportunities.
Investment Ideas for You
So, what to do? Turning our attention to hotel REITs and CMBS, strengths may be found in other REITs sectors that are less vulnerable to interest rate fluctuations or have strong underlying assets, such as Industrial REITs or Residential REITs. Remember, though, that all investments come with risks, and what worked in the past may not work in the future. Always balance your portfolio according to your risk appetite and horizon.
While it’s too late for those already holding the bag on their investment, it’s a valuable lesson for the rest of us in how not to invest. Recognizing the warning signs, understanding the market dynamics, and making prudent investment decisions is crucial. After all, it’s your hard-earned money on the line.
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